Do math before refinancing

Sunday

Dec 28, 2008 at 2:00 AM

The availability of easy credit over the past few decades created a false sense of economic prosperity. Advertising, as well as media coverage of lavish lifestyles, encouraged us to purchase whatever we wanted: luxury cars, big houses, designer clothing and accessories, without having to save or wait for it.

Elaine B. Morgillo, CFP

The availability of easy credit over the past few decades created a false sense of economic prosperity. Advertising, as well as media coverage of lavish lifestyles, encouraged us to purchase whatever we wanted: luxury cars, big houses, designer clothing and accessories, without having to save or wait for it.

Lenders created exotic loan products and often sold them to poorly qualified applicants. The dramatic rise in real estate values between the mid 1990s and 2006 gave millions of people the illusion that their home was the "golden ticket" that would finance both their current lifestyle and their future retirement. Zero-interest credit card offers seduced many folks into thinking they could extend their debt repayment almost indefinitely.

For a while, our economy soared, but it did so on an unsustainable foundation. Now we're suffering the consequences of those excesses.

Within the past weeks, our government has sent a strong message that it will do whatever is necessary to stimulate the economy. In an attempt to encourage home buying and business lending, the Federal Reserve has announced that it plans to keep interest rates low and make an almost unlimited supply of money available to financial institutions. The first reaction to this news has been an increase in mortgage refinancing.

If you're wondering whether you'd benefit from refinancing your existing mortgage, do a little math before calling your mortgage broker. Following is an example to help you:

John bought a condo four years ago for $250,000. He made a $50,000 down payment and obtained a 30-year mortgage for $200,000 at 6.5 percent with a monthly payment of $1,257.32. After four years, his loan balance is $190,491. John's overtime pay was recently eliminated, and he is looking for ways to cut his expenses.

The condo is currently valued at $240,000: less than he paid for it, but fortunately enough to allow him to refinance. He can refinance his loan at a fixed rate of 5.75 percent for 30 years with no points and no closing costs, for a new monthly payment of $1,106.35, a savings of $151 per month.

Doesn't that sound like a good plan? Let's check the numbers another way to see if it is. If John keeps the new loan for the full 30 years he will have made payments totaling $398,286 ($1,106.35 x 12 x 30). If he had kept his original loan, he would have made additional payments of $392,284 (1,257.32 x 12 x 26), or $6,002 LESS than the loan with the lower interest rate. In addition, the original loan would have been paid off four years sooner than the new loan. Does this mean he shouldn't have refinanced? Not necessarily.

If John refinances but increases his monthly payments just a bit, to $1,172 instead of $1,106 (which is still $85 per month less than his original payment) the loan will be paid off in 26 years instead of 30, and his total outlay will be $365,735.49 — $26,549 less than the remaining payment on his original loan. If John invests the $85 per month differential, he can have an additional bonus. At an average annual rate of return of 6 percent, his monthly contributions can grow to $63,904 by the time his mortgage is paid off. If he deposits the contributions into a Roth IRA, he'll have the added benefit of income tax-free growth of his investment.

Despite reports to the contrary, it isn't impossible to obtain credit. The mortgage rates you're seeing advertised lately are usually the lenders' best rates, which are now available to only the most highly qualified buyers. If your credit score is below 700, or if you don't have much equity in your property, your search for a low rate loan will be a greater challenge.

Lenders are definitely more cautious nowadays, as they should always have been, about both the credit-worthiness of their borrowers and the existence of sufficient equity to collateralize the debt, but money is available to those who meet the criteria.

For many reasons, this recession is likely to be deeper and longer than average, but I'm confident the economy will eventually recover. As we approach 2009, let's not forget the lessons we've learned from this painful experience.

Elaine Morgillo is a Certified Financial Planner and president of Morgillo Financial Management Inc. She can be reached at emorgillo@morgillofinancial.com.

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